Fiscal policy Group: mm-72


The Loanable Funds Market


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Fiscal policy

The Loanable Funds Market: A nation's loanable funds market represents the money in commercial banks that is available to be loaned out to firms and households to finance private investment and consumption.

The Crowding-out effect

Illustrating the Crowding-out Effect in the Loanable Funds Market

When a government borrows in order to finance a budget deficit, it must increase the interest rates on its bonds in order to attract more lenders.

  • This causes the supply of loanable funds to decrease, leading to higher borrowing costs in the private sector.
    • Before the expansionary fiscal policy, the level investment was Qpr.
    • Higher interest rates on government bonds cause the supply of loanable funds to decrease to S1.
    • Less money in banks leads to higher interest rates. The quantity funds demanded for private investment falls to Qp.
    • Overall spending increases to Qg, but there is a decrease in private investment of Qp-Qpr


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